Cost of Production ETP Economics 101

Firm’s Objective The Firm’s Objective The economic goal of the firm is to maximize profits.

Total Revenue and Total Cost The amount a firm receives for the sale of its output. R(Q)=P(Q) *Q Total Cost The market value of the inputs a firm uses in production. C(Q)

Profit = Total revenue - Total cost Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost Profit (Q)=R(Q)-C(Q)

Firm’s Cost of Production A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.

Economic Profit and Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit.

Figure 1 Economic versus Accountants How an Accountant How an Economist Views a Firm Views a Firm Revenue Economic profit Accounting profit Revenue Implicit costs Total opportunity costs Explicit costs Explicit costs Copyright © 2004 South-Western

Example: Joe runs a small boat factory Joe can make 10 boats/year and can sell them for $25,000 each. It costs Joe $150,000 for raw materials. Joe Invests $400,000 in factory and equipments: $200,000 from his own savings and $200,000 borrowed at 10% interest (assume Joe could have loaned his money out at 10% interest). Joe can work at a competing boat factory for $70,000/year.

Example: continued Total revenue=10*25,000=$250,000 Explicit costs =$150,000+($200,000*0.1)=$170,000 Total opportunity costs=Explicit +Implicit =[$150,000+($200,000*0.1)]+[($200,000*0.1)+$70 ,000]=$260,000 Accounting profit=$250,000-$170,000=$80,000 Economic profit=$250,000-$260,000=-$10,000

Production Function The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. Q= f(L, K), where L is labor and K is capital

Marginal Product Marginal Product The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. Diminishing Marginal Product Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers (labors) are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment (capital).

Figure 2 Hungry Helen’s Production Function Quantity of Output (cookies per hour) 150 Production function 140 130 120 110 100 90 80 70 60 50 40 30 20 10 1 2 3 4 5 Number of Workers Hired Copyright © 2004 South-Western

Slope of Production Function Diminishing Marginal Product The slope of the production function measures the marginal product of an input, such as a worker. When the marginal product declines, the production function becomes flatter.

Production Function and Total Cost Curve The relationship between the quantity a firm can produce and its costs determines pricing decisions. The total-cost curve shows this relationship graphically.

Figure 3 Hungry Helen’s Total-Cost Curve $80 Total-cost curve 70 60 50 40 30 20 10 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity of Output (cookies per hour) Copyright © 2004 South-Western

Fixed and Variable Costs Costs of production may be divided into fixed costs and variable costs. Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced.

Formula of Total Cost Total Costs (TC) Total Fixed Costs (TFC) Total Variable Costs (TVC) TC = TFC + TVC

Average Costs Average Costs Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC

AVERAGE COSTS

Marginal Costs Marginal Cost Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output?

Formula of Marginal Cost

Note Marginal Cost = Change in Total Cost/Change in Quantity = Change in Variable Cost/Change in Quantity

Case: Thirsty Thelma’s Lemonade Stand

Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves Costs $3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 AVC 1.00 0.75 0.50 AFC 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Marginal Cost Curve and Its Shape Marginal cost rises with the amount of output produced. This reflects the property of diminishing marginal product.

Average Total Cost Curve and Its Shape The average total-cost curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

Relationship between MC and ATC Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. The marginal-cost curve crosses the average-total-cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost.

Typical Cost Curves It is now time to examine the relationships that exist between the different measures of cost.

Figure 6 Big Bob’s Cost Curves (a) Total-Cost Curve Total Cost $18.00 TC 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 2 4 6 8 10 12 14 Quantity of Output (bagels per hour) Copyright © 2004 South-Western

Figure 6 Big Bob’s Cost Curves (b) Marginal- and Average-Cost Curves Costs $3.00 2.50 MC 2.00 1.50 ATC AVC 1.00 0.50 AFC 2 4 6 8 10 12 14 Quantity of Output (bagels per hour) Copyright © 2004 South-Western

Properties of Typical Cost Curves Important Properties of Cost Curves Marginal cost eventually rises with the quantity of output. The average-total-cost curve is U-shaped. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. The marginal-cost curve crosses the average-variable cost curve at the minimum of average variable cost.

Costs in the Short Run and in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run, some costs are fixed. In the long run, fixed costs become variable costs.

Short-Run Cost Curves and Long-Run Cost Curves Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost $12,000 ATC in long run 1,200 Quantity of Cars per Day Copyright © 2004 South-Western

Economies of Scale? Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost ATC in long run Economies of scale Diseconomies of scale 1,200 $12,000 1,000 10,000 Constant returns to scale Quantity of Cars per Day Copyright © 2004 South-Western